Liquidity risk premium

Academic research shows liquidity risk premium is an independent risk factor. Liquid assets are discounted in price, while more liquid assets have higher prices for the same set of expected cash flows. Less liquid assets have higher expected returns, while more liquid assets have lower expected returns. Investors require an additional return for holding illiquid assets. Therefore, this pattern holds in nearly every asset and higher performance for less liquid assets.

We advise reading research by Amihud in which he presented a return factor of illiquid-minus-liquid stocks called IML, which provides a time series of the illiquidity premium. He also states that the risk-adjusted predicted return on IML is the predicted response to market illiquidity shocks. Pastor, Stambaug respond to two other studies (The Critical Finance Review – Li, Novy-Marx, and Velikov (2017) and Pontiff and Singla (2019)) by offering related thoughts, such as when to use traded versus non-traded liquidity factors and how to improve the precision of liquidity beta estimates.

In conclusion, the liquidity risk premium is an economically significant investment style or stock-picking strategy that is just as strong, but distinct from traditional investment styles such as size factor, value (book-to-market) factor, and momentum effect in stocks, which has led to excess returns relative to already mentioned investment styles. When converted into less liquid versus more liquid liquidity factor, liquidity is negatively associated with the market and size factors, but positively associated with value and momentum factors. One reason that less liquid stocks outperform is that they are valued at a liquidity discount, thus generating extra returns. Another reason is that stocks tend to migrate toward normal trading volume over time, increasing less liquid valuations while decreasing more liquid valuations.

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